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Like the yellow happy face that bounces through the aisles in its television ads, Wal-Mart is leaping across the world – planting giant supercenters as well as neighborhood-scale markets in a continued expansion that has already made it the world’s largest company.

Wal-Mart is not only a retailer, but a sophisticated distribution company that rang up $246 billion in revenue last year at 4,414 stores in the United States and nine foreign countries. It has 1.3 million employees, but continues to project a folksy down-home image that includes a company cheer.

For the second year in a row Wal-Mart topped Fortune Magazine’s list of largest companies and is also the magazine’s most-admired firm, the first time one company has shared both honors since the magazine began its annual survey in 1955.

In addition, as the nation’s largest private employer, Wal-Mart is integrally tied to America’s heartland. According to a recent article in the New York Times, Wal-Mart stores frequently function as a “substitute town square,” especially in areas located near military installations. During the past few weeks, Wal-Mart employees and customers, many of whom are related to someone involved in the Iraqi war, have used local stores as a place to share information and concerns over loved ones.

Sheer size is clearly a factor. “There’s no one bigger,” says William Cody, managing director of the Jay H. Baker Retailing Initiative at Wharton. “Wal-Mart is obviously doing something well considering the competitive nature of retailing. The company has a simple formula of low prices and rocket-science logistics to back up its operations. There’s no secret to its success.”

Despite its conquests, the company plans to expand more aggressively into the Northeastern United States, California and abroad. The goal is to add 48 million square feet of store space this year, which would increase Wal-Mart’s size by 8%.

With that expansion will come new challenges, primarily fending off unions and keeping in touch with local consumer tastes. “Wal-Mart is starting to open up to more difficult challenges,” says

Stephen Hoch, chair of Wharton’s marketing department. “But it’s a very well-run company. Although I wouldn’t say Wal-Mart is a great marketer, it has done a good job in building a brand people trust.”

Getting Smaller to Get Bigger

Headquartered in Bentonville, Ark., the company was founded in 1962 by Sam Walton whose family is still active in the business. Since the beginning, Wal-Mart has maintained a singular focus on providing the lowest prices to its customers.

The company’s primary expansion strategy is to increase the number of its massive, 100,000-210,000 square-foot supercenters. Introduced in 1988, supercenters combine the general merchandise offerings at Wal-Mart’s standard discount stores with groceries, fresh food and bakery items.

The company currently operates 1,603 Wal-Mart discount stores and 1,179 supercenters. This year it plans to add 45 to 55 Wal-Mart stores and 200 to 210 supercenters, 140 of them conversions of former discount stores.

Retail Forward, an Ohio retail consulting firm, estimates that supercenters account for 58% of Wal-Mart’s domestic sales, noting that half its supercenters are located in 11 states of the Old South.

According to Ira Kalish, chief economist at Retail Forward, Wal-Mart offers lower prices on food to bring traffic into the supercenters where customers will also buy other more profitable merchandise. Retail Forward estimates that Wal-Mart food prices are about 15% lower than other supermarkets because of its superior sourcing operations and non-union labor. “The supercenter is a unique operational model in which food is almost a loss leader that drives frequent traffic into the store,” says Kalish.

Hoch predicts that Wal-Mart can bring increased efficiencies to the fragmented and regional food industry: “It’s not a very concentrated industry. But as food manufacturing and the production of fresh food becomes more and more global – with 24-7 radicchio – it’s not just the local source of supply [that is available.]”

The company is also experimenting with a concept it calls the neighborhood market, a 60,000-square foot store with general merchandise and convenience items, including drive-through pharmacies, ready-cooked meals and one-hour photo-processing. The markets are designed to fill in the gaps between supercenters. In Oklahoma City, where Wal-Mart has intentionally attempted to saturate the area, supercenters are placed five miles apart, with neighborhood markets spaced two miles away. The company now has 36 neighborhood markets and plans to add 20 to 25 this year.

“The majority of the growth in raw numbers comes from the supercenter conversions, but in terms of new strategy it’s the neighborhood markets,” says Tom Goetzinger, an analyst who follows Wal-Mart at Morningstar, Inc. “This is a way to try to enter the very dense, potentially more expensive areas of the country.”

According to Cody, the neighborhood market is not likely to cannibalize existing supercenters. The idea is to take sales from smaller convenience stores and supermarkets where customers may stop more frequently than they would at the massive supercenter. “Wal-Mart might not have gotten that portion of the consumer’s dollar anyway,” he says. “There is always the problem of saturation, but they still need to grow somehow, so getting smaller is probably the best way to grow.”

King of Logistics

While projecting an image as a simple country retailer, Wal-Mart has been highly successful in using computer technology to make its business more efficient. “Wal-Mart has done an amazing job as a logistics company in a way that the average person doesn’t appreciate,” says Robert Mittelstaedt, director of Wharton’s Aresty Institute of Executive Education.

It is a common misperception that Wal-Mart’s ability to keep prices low stems primarily from its size and resulting clout with suppliers, he notes. Actually, the savings come largely from Wal-Mart’s efficiency as a distribution company that benefits not only Wal-Mart, but its suppliers as well.

According to Mittelstaedt, suppliers at first resisted sharing information because they felt it would hurt their competitive position. Now they have come to embrace the system. For example, Wal-Mart works closely with suppliers integrating their data with its own to monitor what items are selling. That allows the company to keep its inventory costs low and allows suppliers to adjust manufacturing up or down, depending on what is selling. Retail Forward estimates that 69% of Wal-Mart’s merchandise was already sold before it had to pay its suppliers last year.

“Wal-Mart looked at this and said, ‘How do we change the model and get the vendor to work more for us?’” says Mittelstaedt. “It’s like the bank getting you to use an ATM. You end up liking it because it is easier for you, too.”

Wal-Mart, he adds, remains one of a few companies that have successfully captured the benefits of new information technology by reengineering its entire business. It has used technology to streamline work, not simply automate existing processes. “Many of the principles we talk about in information technology – changing the nature of work – still haven’t been implemented by most companies. We persist in automating existing processes rather than asking the question, ‘How do we eliminate the processes and make it simple?’”

Wal-Mart, says Mittelstaedt, is now experimenting with new technology known as radio frequency identification (RFID) in which tiny chips embedded in products or packaging emit radio signals to hand-held receivers. An employee could use the system to quickly count how many units of each product are on the shelf simply by walking down the aisle. The technology could streamline Wal-Mart inventory management even more than today’s scanner technology.

This technology is still in the experimental stage, he adds, and may face opposition from privacy advocates arguing that, at least in theory, someone could drive down a street and determine how many Schick or Gillette razor blades are in the family medicine chest. He suggests that the use of RFID will become more likely as the cost of the chips continues to drop.

Mittelstaedt says the ability to recognize the potential of new technology lies in Wal-Mart’s corporate culture of frugality. “It’s called being cheap, and only making investments with a guaranteed payback.”

This mindset goes beyond technology and comes into play in everything Wal-Mart does, Cody adds. “They’re penny-pinchers and that culture pervades the entire organization. When you’re focusing on how every nickel is spent, you’re making more prudent financial decisions.”

According to Hoch, a hallmark of the company’s culture is the ability to maintain its focus. “One of the things that I respect is that Wal-Mart knows what it does, and it does it well. I think there is a tendency for retailers – once they have an installed base of customers – to deviate. Sometimes that’s fine, but sometimes it monkeys up the whole works.”

For example, he says, the company could probably make effective use of price discrimination by raising prices slightly on high-demand items. “It is leaving money on the table. But Wal-Mart feels that by not [engaging in] price discrimination it can be more focused on reducing costs and creating this long-term price perception which is more valuable than short-term opportunistic gains.”

Wal-Mart is also looking abroad for future sales growth. The company, according to Cody, is doing well with its 40 stores in China, which are transforming the way the world’s most populous country shops – from a daily trip to the local market where fresh food is sold on the street to a big bright store filled with packaged goods. Yet he cautioned that Chinese consumers have just 10% of the purchasing power of U.S. buyers.

Wal-Mart, he suggests, is paying close attention to local customs and tastes, after running into trouble in Germany where store operation rules and union protections were not in the Wal-Mart playbook. “The company tried to offload Bentonville onto international markets based on its success in the U.S. Through some hiccups in Germany it found it needs to understand the local culture.”

Wal-Mart’s international expansion has worked better in markets where the company bought existing retailers, including England, rather than importing its own stores directly, according to Kalish. “In many other places it’s gone, it has had a hard time entering into the local market and absorbing the local politics into the corporate culture.” The result has been “serious mistakes in localized merchandise.”

The Costco Challenge

While Wal-Mart seems unstoppable, there are a few red flags.

Cody suggests that as the business grows ever larger and more far-flung, Wal-Mart will need to struggle against the urge to centralize operations and eliminate decision making from the frontlines where managers have face-to-face contact with customers. “If the home office becomes more of a bureaucracy, that’s where it could run into trouble.”

Another weakness, Cody adds, is in its 500 Sam’s warehouse clubs, which have not done well against Costco. “The only area in which Wal-Mart has not been able to pummel its competition is against Costco.”

In addition, even though it is the nation’s largest apparel retailer with more than 12% of the market, Wal-Mart could be doing better in this category, Kalish says, noting that Wal-Mart has hired an executive from The Limited, a fashion retailer, to beef up this line of business.

“Wal-Mart is the largest clothing retailer but it’s mostly basics like socks and underwear,” Kalish points out. “It would like to be a fashion retailer and take on Target with good quality at a low price-point, but it hasn’t convinced the American consumer it should be a destination for casual fashion.”

Union Blues

Indeed the prospect of unionization is a major headache for Wal-Mart.

“One of the legs up that Wal-Mart has over traditional supermarket chains is that it is not unionized,” says Hoch. “Can it avoid being unionized? The answer is, ‘yes.’ But when the company goes into heavily populated areas where there are unions I think it will have union opposition in terms of public relations or with union shippers. Wal-Mart may just decide not to go there.”

Kalish says union organizing efforts have popped up against the company and a few managers have been found in violation of labor laws. A federal lawsuit filed in California alleges the company discriminates against women when it comes to promotions. And Wal-Mart recently suspended all gun sales in California after more than 500 violations of state firearms laws were found at six stores. The company said it would upgrade employee training.

Even at its size, Kalish says Wal-Mart need not worry about government anti-trust actions. Wal-Mart accounts for 8% to 9% of all U.S. retail sales, a much lower concentration than is typically found in other consolidated industries. Local governments, however, can be problematic for Wal-Mart when it comes to winning zoning approval for new stores, and other regulatory issues, particularly if unions use local government to try to keep non-union competition away.

But despite these challenges, Wal-Mart is not at the point where it is facing market saturation, says Goetzinger. He suggests that home improvement superstores Home Depot and Lowe’s probably will reach that point in two or three years, but because Wal-Mart carries such a broad line of products there is still room to grow.

However, he does not expect the chain to rack up continued 15% growth. In the next five years he predicts revenue increases will be closer to 10%. “But who knows?” Goetzinger says. “This company is an absolute benchmark for successful management.”